Order Code RL30839
CRS Report for Congress
Received through the CRS Web
Tax Cuts, the Business Cycle,
and Economic Growth:
A Macroeconomic Analysis
Updated October 5, 2001
Marc Labonte
Economist
Government and Finance Division
Gail Makinen
Specialist in Economic Policy
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Tax Cuts, the Business Cycle, and Economic Growth:
A Macroeconomic Analysis
Summary
With reports of an economic downturn, support has been mounting for an
additional tax cut this year to stimulate the economy. Regardless of the implications
of tax levels and structure for equity, fairness, intergenerational debt burden, and the
role and size of government, any tax reduction will affect the macroeconomy. This
report is limited to analyzing these macroeconomic effects.
Tax cuts have distinct short run and long run effects. Oftentimes, they are at
odds with each other. In the short run, tax cuts that are funded through a reduced
surplus increase aggregate demand and influence the business cycle if they are spent.
If the economy is in recession, then the tax cuts are likely to raise growth in the short
run. If the economy is operating at full capacity, the boost in aggregate demand will
quickly be dissipated through higher interest rates, inflation, and a larger trade deficit.
If a tax cut is meant to prevent a recession by providing a short-term stimulus, its
efficacy should be judged by how much spending (or dissaving) it generates.
The efficacy of a tax cut that is meant to boost long-run growth should be judged
by how much additional work, net saving, and investment it generates. Empirical
estimates as to how much of a behavioral response can be expected when taxes are
cut are inconclusive. These effects are likely to be negligible in the short run if the
economy is in a recession. If the tax cuts are funded through a reduced surplus (i.e.,
less government saving), this will have a negative effect on national saving, reducing
long run growth. The extent that national saving falls is determined by how much
new private saving offsets the fall in government saving.
Since saving is the opposite of spending, it is difficult to craft a tax cut which can
boost growth in both the short run and long run. If tax cuts to individuals (e.g,
payroll or income tax reductions) are spent to end a recession, then long run growth
will suffer because of the reduction in national saving. Tax cuts aimed towards higher
saving (e.g., a reduction in the capital gains tax) are unlikely to prevent a recession
because they will generate little additional short-run spending. Reductions in business
taxes (e.g., reduction in corporate tax rates, an investment tax credit) could boost
both short-run spending and long-run growth through higher investment. There is
uncertainty, however, as to how great a short-run investment response could be
expected in a recession and whether the tax cut would generate enough private saving
to offset the decline in public saving.
Theory suggests, and arguably the past two decades demonstrate, that monetary
policy is a superior tool for ironing out the ebb and flow of the business cycle because
of exchange rate effects and because it can be implemented more quickly. Most
historical recessions have ended without the use of fiscal policy. At present, political
inhibitions concerning a return to a unified budget deficit may prevent a tax cut from
being large enough to boost aggregate demand significantly. Moreover, with the
expansionary policies already in place and the economy not yet in recession, questions
have been raised about the need for further tax cuts to stimulate aggregate demand.
This report will be updated as events warrant.

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Contents
The Short Run Effects of Tax Reduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
A Fully Employed Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Globalization Complicates Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . 3
Key Variables in the Conventional Model . . . . . . . . . . . . . . . . . . . . . . 4
Would the Tax Cut Crowd Out With Unemployed Resources? . . . . . . 4
Supply Side Effects in the Short Run . . . . . . . . . . . . . . . . . . . . . . . . . 5
Criticisms of the Use of Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Never a Good Time for Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . 5
Slowdown Was Necessary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Stimulus Already in Place . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
High Long-Term Interest Rates Preventing Recovery . . . . . . . . . . . . . 6
Monetary Policy Provides a Better Stabilization Tool . . . . . . . . . . . . . 7
The Longer Run Effects of Tax Reduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Evaluating the Long Term Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Would a Permanent or Temporary Tax Cut Be a More Effective Stimulus? . . . 14
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

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Tax Cuts, the Business Cycle, and
Economic Growth: A Macroeconomic
Analysis
On June 7, 2001, the Economic Growth and Tax Relief Reconciliation Act of
2001 (EGTRRA, P.L.107-16) was signed into law. Its provisions are forecast to
lower tax revenues by $1.3 trillion over the next 10 years. Due to concerns about the
potential for economic recession, heightened by the events of September 11, many
members of both parties have called for a further round of tax cuts as an additional
stimulus to the economy.
While the level of taxation is a perennial issue because it bears ultimately on the
size of the government relative to the private sector, three major arguments for tax
reductions have emerged in the current dialogue. The first is the need to combat an
economic slowdown. While individuals making this argument disagree about what
the government’s fiscal position should be and ought to be in the long run, they are
most concerned about the very near term. They argue that a good dose of fiscal
stimulus is needed now to keep the U.S. economy on the steady path of full
employment growth. Second, it is argued that in the long run tax cuts will boost the
sustainable rate of growth by creating incentives to work, save, and invest. Third, it
is argued that the presence of large surpluses would encourage Congress to
undertake“wasteful” spending and, therefore, a tax cut would help maintain fiscal
discipline.1
Any tax cut that is considered will be influenced by the reduction in the projected
fiscal position of the government since the beginning of 2001. In the long run, this
is due primarily to legislative changes, particularly EGTRRA, which reduced the
projected 10-year budget surplus by an estimated $1.66 trillion (reducing tax revenues
by $1.3 trillion and raising debt payments by $0.36 trillion). In the short run, the
government’s fiscal position is exacerbated by emergency outlays in response to the
events of September 11 and will likely be exacerbated by slower growth over the next
couple of years than was projected in the most recent budget forecast. These factors
suggest that a tax cut would need to be quite modest in size – probably less than 1%
of gross domestic product (GDP) – to avoid a unified budget deficit in 2002 and a
non-Social Security deficit in later years. Yet any tax cut that sought to avoid a
budget deficit would be too small to offer a large boost to GDP.
Regardless of which arguments propel the tax cut debate, all will have to face the
fact that a tax cut will affect the macroeconomy. This report explores what these
1 A crucial simplifying assumption made in this analysis is that the budget surplus would be
maintained in the absence of a tax cut. If this is not true, as the third argument suggests, then
the conclusions reached in this report would be different.

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CRS-2
effects could be. It addresses only the first two of the arguments above. It does not
address the questions of how the size of the surplus affects fiscal decisions. The
discussion to follow breaks the analysis of the macroeconomic effects of tax reduction
into two parts. The first concentrates on the short run, while the second discusses the
longer run consequences. The short run effects concern how a tax cut would affect
the business cycle. The long run effects concern how a tax cut would affect the long-
term sustainable rate of growth. The analysis in this report will focus on the
macroeconomic effects of a tax reduction. While this analysis focuses on tax
reductions because of topical interest and for reasons of analytical ease, the thrust of
the analysis also applies to virtually any increase in government spending that is
financed through a reduced budget surplus.
The Short Run Effects of Tax Reduction
The analysis of the short run effects of a tax cut will begin by assuming that the
economy is characterized by full employment. This is done to focus on the variables
that are thought to be important in gauging the ability of a fiscal stimulus to work in
the short run. Later, this assumption will be modified and tax cuts will be analyzed
in an economy characterized by unemployed resources.
A Fully Employed Economy.2 The effects of a tax reduction in the
mainstream macroeconomic model (the Mundell-Fleming model) are straightforward.
For most tax cuts to individuals, the cut in taxes would increase the disposable income
of households. Households are assumed to follow historical patterns and spend much
of this increase.3 This increase in household spending will directly and indirectly
stimulate aggregate demand.4 Likewise, the stimulative effect of business tax cuts
would come from the fact that some portion of the tax cut would be spent on new
investment, although there is much less agreement among economists that a large
fraction of the tax cut would be quickly spent. The reaction of the economy to this
stimulus will be felt in the markets for money, credit, and goods and services. In a
fully employed economy, these markets must adjust to ration the available supply of
output over the now enlarged and competing demands for it.
2 Economists define full employment as the rate of unemployment consistent with a stable rate
of inflation. Current estimates of this rate tend to cluster around 5%. By this measure, the
current unemployment rate places the current level of gross domestic product near full
employment despite the recent slowdown. See, CRS Report RL30391 Inflation and
Unemployment: What Is the Connection? by Brian Cashell, and CRS Report RL30738. Why
Has the Unemployment Rate Fallen When Inflation Is Stable?, by Marc Labonte,
3 By contrast, a reduction in the capital gains tax would likely reduce spending and contract
aggregate demand because it encourages saving through certain types of assets (e.g., equities).
4 Similarly, an increase in government spending that was financed through a reduction in the
surplus would directly and indirectly stimulate aggregate demand, with the only difference
being that individuals would save some portion of the tax cut, diluting its stimulative effect,
while the government would spend the entire reduction in the surplus.

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In the market for credit, expansionary fiscal policy is equivalent to a decrease in
the national saving rate.5 Since less saving is available for private investment, real or
inflation adjusted interest rates must rise to keep the credit market in equilibrium. In
the market for money, the increase in spending increases the demand for money.
Assuming for analytical purposes that the supply of money does not increase (i.e., the
posture of monetary policy is unchanged):
! Interest rates must rise to restore equilibrium between money demand and
money supply.
! Interest sensitive spending would fall as a consequence.
! The increase in aggregate demand, or spending, would cause the price level to
rise (or the on-going inflation rate to rise) to bring the markets for goods and
services back into equilibrium.
! This, in turn, would reduce the real value of the existing money holdings of the
public.
! A fall in the real value of money holdings would also tend to reduce spending
and put additional upward pressure on interest rates to restore balance between
aggregate demand and the full employment level of supply.
To recap, unless households saved all of their increase in disposable income, the
net effect of a tax cut to individuals is that a reduced budget surplus would reduce the
national savings rate and encourage additional consumption spending. As a result,
interest sensitive spending, which is largely spending by businesses on capital goods,
would be reduced or “crowded out.” In the case of corporate tax cuts, investment
spending would be simultaneously boosted by lower tax rates (for incorporated
businesses) and lowered by higher interest rates (for all businesses), and all sectors of
the economy would be affected by higher inflation. Thus, at full employment,
conventional macroeconomic theory suggests that the net effect of a tax cut would
be small or nil because the economy does not have unused resources (labor and
capital) that can be brought into employment. The increase in aggregate demand is
dissipated through higher interest rates and/or inflation, reallocating output among
sectors of the economy but leaving aggregate output unchanged.
Globalization Complicates Fiscal Policy. However, in an open economy,
or one in which foreign trade and capital flows are important, the adjustment to
additional fiscal stimulus can be quite different. The upward pressure on interest rates
can have a significant international effect. To the extent that international capital
flows are highly sensitive to interest rate differentials, as they appear to be for the
United States, foreigners will respond to rising U.S. interest rates by flocking to buy
American assets (stocks, bonds, and real estate). Before they can buy American
assets, they must first buy dollars. This action would increase the demand for dollars
5 To see how reducing the surplus lowers national saving, consider the similarity between
households and the government. The saving of the household sector is equal to its after tax
income less the portion of that income that it uses to buy goods and services. Analogously,
the saving of the government, or its budget surplus, is equal to its revenue less its outlays.
When the revenue is reduced by a tax cut but government spending remains the same, the
surplus, and, hence, government saving declines. Thus, national saving will decline unless
households save the entire tax cut and do not use it for greater consumption. This is unlikely
to happen, and if it did, the tax cut would not have a stimulative effect on the economy, since
aggregate demand would be unchanged.

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and the dollar would appreciate. Dollar appreciation would, in turn, increase the price
of American goods in foreign countries and decrease the price of foreign goods in the
United States. This price decrease would help offset some of the inflationary
pressures caused by the tax cut. As a result, Americans would tend to spend more on
foreign goods and foreigners less on American goods, enlarging the trade deficit. As
with the closed economy, the tax cut would not affect the growth of real output
because the (fully employed) economy does not have unused resources to employ.
The difference in the open economy is that the increase in aggregate demand is instead
dissipated through the exchange rate and the current account of the balance of
payments, reallocating output away from exports and import substitutes, rather than
through investment spending.6
Key Variables in the Conventional Model. The analysis above, conducted
within the confines of the conventional macroeconomic model, highlights the variables
that are important in deciding whether a fiscal stimulus will be successful. First, does
the stimulus raise real interest rates? If it does, it will discourage or “crowd out”
interest sensitive spending in the private sector. And this is likely to be spending on
capital goods. Second, will any increase in United States interest rates relative to
those in foreign countries draw foreign capital to the United States and/or encourage
American capital that would have gone abroad to stay at home? If it does, then the
United States will have to contend with an appreciating dollar and a growing foreign
trade deficit. Third, is this net flow highly sensitive to small differentials in
international interest rates? If it is, then “crowding out” in the United States will be
heavily concentrated in the export and import competing sectors. There would be
little crowding out in the capital goods sector, but an increasing proportion of the new
capital goods put in place would be owned by foreigners.
Because the United States is linked to its trading partners with flexible exchange
rates, and the international mobility of capital to the United States appears to be both
high and rising over time, it is not uncommon for many American economists,
analyzing tax cuts in terms of the conventional model, to conclude that the potential
demand stimulus from such cuts will be dissipated or offset by an enlarged trade
deficit.
Would the Tax Cut Crowd Out With Unemployed Resources? The
analysis above is based on the assumption that the economy is at full employment. If
this were not the case, would the additional household spending from the individual
tax cuts increase aggregate spending and help bring the economy back to full
employment? The answer to this question depends on whether the increased demand
would raise interest rates and whether the increase in rates would draw capital from
6 The Kennedy tax cuts proposed in 1961 are often cited as a successful example of using
fiscal stimulus to avoid a recession. But the economy of that era was vastly different from
today’s economy, which features high, unimpeded capital mobility and a freely floating
exchange rate. Under today’s regime, a fiscal stimulus is much more likely to be dissipated
through lower net exports. Thus, the closed economy analysis may be more useful for
evaluating the Kennedy tax cuts while the open economy analysis may be more useful today.

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abroad.7 Theory can provide no single answer to this question, since a situation of
“unemployed resources” is compatible with a variety of different circumstances. In
a dire recession, investment would be expected to be highly unresponsive to changes
in interest rates and the stimulative effects tax cuts would not be significantly crowded
out.8 The closer the economy is to full employment when the effects of the fiscal
stimulus are felt, the more likely it is to track the predictions that come from the
analysis of a fully employed economy spelled out above.9
Supply Side Effects in the Short Run. The discussion above has
concentrated on the demand-side effects of a tax cut. But cuts in tax rates can also
have supply side effects. They can affect the incentives to work, save, and invest. In
the short run, these changes are likely to be small because people’s behavior changes
gradually. Furthermore, greater work effort and investment in response to tax cuts
are unlikely to occur at all in the short run if the economy is in recession. That is
because people are unlikely to supply more labor and capital when existing labor and
capital are already underutilized. In the long run, however, these changes may be
important, as explained below. Thus, tax cuts may help end a recession through their
effects on aggregate demand, but not through their effects on aggregate supply.
Criticisms of the Use of Fiscal Policy
Five major macroeconomics concerns have emerged about using fiscal policy at
this time.
Never a Good Time for Fiscal Policy. First, there are a group of
economists who feel that the use of fiscal policy as a short-run stabilization tool has
had poor results in the post-war period.10 To be an effective stabilization tool, fiscal
policy should be changed frequently, quickly, and in both directions as circumstances
require. In other words, taxes cannot be merely cut during a recession, they must be
raised during an expansion. The empirical record does not demonstrate that fiscal
policy has been successful on the basis of any of the three criteria. The tax cut
proposed by President Kennedy to head off recession in 1961 was not implemented
until 1964. And most economists were highly critical of the fact that the use of fiscal
policy in practice led to budget deficits in all but one year from 1961 to 1997. In the
minds of these economists, fiscal policy should be used only as a last resort when all
else has failed. They point to the fact that most economic slowdowns have ended
7 It is important to note that in the analysis to follow economic conditions in the rest of the
world, notably foreign interest rates, are assumed to be unchanged for analytical ease.
8 In a situation where crowding out did not exist because investment was insensitive to higher
interest rates, it is doubtful whether reductions in corporate taxes would offer short run
stimulus since they also affect the rate of return on investment.
9 It is interesting to note that the although the tax cuts of the early 1980s took place during a
severe recession, there was still a strong currency appreciation and expansion of the current
account deficit in the following years.
10 For example, see John Taylor, “Reassessing Discretionary Fiscal Policy,” Journal of
Economic Perspectives, v. 14, n. 3, Summer 2000, p.21.

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CRS-6
without any change in fiscal policy. They are likely to have a firm belief that monetary
policy can solve all but the worse economic slowdowns.
Slowdown Was Necessary. Has the economy reached these sort of dire
straits? There are a group of economists who believe that, on the contrary, some type
of slowdown was necessary to maintain the current expansion. While the current
slowdown is undoubtedly sharper than these economists would have desired, they
believe the economy to have been incapable of continuing at the pace of early 2000.
Although many economists now believe that the economy is capable of growing more
rapidly than it did over the early 1990s, they do not believe that sustained rates of
growth in the 4% range are possible over the longer run. From their perspective,
slower growth should not be viewed as constituting an economy below “full
employment.” If growth had not slowed to a more sustainable pace, they believe that
higher inflation would have occurred. Thus, from this perspective, too much
additional fiscal stimulus could make a needed “soft landing” harder to achieve.
Stimulus Already in Place. Whether or not one favors the use of fiscal
policy as a stabilization tool, the economy will be receiving stimulus from three
different government sources in the short term. There has been a loosening of
monetary policy throughout 2001 that was redoubled in the wake of September 11.
Overnight interest rates were reduced by 3 percentage points in the first eight months
of 2001 and a further one percentage point since September 11. Emergency
appropriations worth $40 billion (P.L.107-38) and relief to the airline industry worth
up to $15 billion (P.L.107-42) in the wake of September 11 constitute expansionary
fiscal policy if they are financed through a reduction in the surplus, as seems certain.
And new provisions of EGTRRA will be phased-in on January 1, 2002. These
phase-ins will result in an additional estimated revenue loss of $31 billion in 2002. In
this light, the question does not revolve around whether or not the economy requires
expansionary policy, but whether it requires a further stimulus beyond the three
expansionary policies already in place.

High Long-Term Interest Rates Preventing Recovery. There are also
concerns that the long run effects of a tax cut will trump its expected stimulative
effects in the short run. A tax cut would embody a shift in the American fiscal regime
from one that emphasizes private capital formation to one that emphasizes
consumption. This issue is explained below in greater detail. From that perspective,
it may have an adverse effect in the short run on business expectations and private
investment spending.
The model presented above suggests that the stimulative effect of a tax cut
would be trumped if it was largely crowded out by higher interest rates and lower
investment spending. Since the current slowdown has been concentrated in the
investment sector, the model would suggest that very little stimulus would be
crowded out at present. Yet an important characteristic of this slowdown is the fact
that long-term interest rates, which are more important in the determination of
investment spending than the short-term rates that the Fed influences, have not
significantly fallen. Many economists fear that investment spending will be sluggish
as long as long-term rates remain high. One theory for why this has occurred is that
investors now believe that the future debt of the government will be larger than
previously expected, raising future interest rates. The expectations hypothesis of the

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term structure of interest rates states that long term interest rates today are the sum
of expected short-term interest rates from now into the future. If lenders expect high
interest rates in the future, then the opportunity cost of long-term borrowing rises
today, and long-term interest rates will remain high today.
Monetary Policy Provides a Better Stabilization Tool. Economists
have long debated the merits of fiscal vs. monetary policy as a tool for ironing out
short run fluctuations in GDP growth. The experience of the last two decades has led
to a growing consensus among economists that monetary policy has several
advantages over fiscal policy.
First, the Board of Governors of the Federal Reserve may have an advantage
over other policymakers in recognizing the onset of an economic contraction. The
12 regional Federal Reserve banks employ a large, specialized staff who play an active
role in gathering information about local economic conditions that they provide to the
Board of Governors. This centralization of information gathering and assessment is
likely to give the Board of Governors a major “recognition” advantage over others,
including Congress.
Second, it is far less time consuming to deliver a monetary stimulus than it is to
deliver a comparable fiscal stimulus. Monetary policy changes can be executed daily
whereas changes in tax rates or expenditures often require considerable deliberations
and procedural maneuvers by Congress. The Fed has reduced its target for the federal
funds rates nine times in 2001 through October 2 by a cumulative total of 4
percentage points, in some cases between scheduled meetings, whereas legislation to
cut taxes takes months to formulate, negotiate, and pass into law.
Once implemented, however, fiscal policy may have an advantage over monetary
policy in a recessionary environment in the length of time it takes to affect GDP
growth. Certain tax changes can immediately affect the take-home pay and spending
of a considerable number of households.11 Monetary policy shifts only affect the
economy after households and businesses respond to changes in interest rates and the
international exchange rate of the dollar. This process is likely to be more time
consuming than changes in the spending behavior of households following changes
in tax rates.
11 Income and payroll tax rate reductions can immediately increase the wage portion of income
through reductions in withholding, but most of the profit portion (or earnings of self employed
individuals) of income will not be affected by a rate change until tax returns are (annually or
quarterly) filed. Of course, disposable income will be increased only when the tax rates go
into effect, which depends on the legislation (i.e., in the next fiscal year or retroactive to a
previous period.) Most other individual tax changes would have an impact on spending only
when tax returns are filed. With reductions in different types of corporate taxes, there would
be less delay expected. Unlike individual tax reductions, which aim to give consumers more
after-tax income to spend or invest, corporate tax reductions aim to stimulate corporate
investment. Although corporations file taxes only quarterly, it is assumed that corporations
would change their behavior as soon as the tax law is changed. A similar argument can be
made for a capital gains tax reduction as well.

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Third, theory suggests that monetary policy can be more powerful than fiscal
policy under a flexible exchange rate regime like the one the U.S. has adopted. This
conclusion is based on a belief that, as discussed above, fiscal expansion can lead to
higher interest rates, all else equal. These higher interest rates attract foreign capital,
which causes the exchange rate to appreciate. When the exchange rate appreciates,
net exports fall, dissipating part or all of the fiscal stimulus. Expansionary monetary
policy, or lowering interest rates, has the opposite effect. Lower interest rates can
lead to more interest-sensitive spending and a depreciated currency, all else being
equal. The depreciated currency makes exports more competitive, increasing net
exports. Thus, expansionary monetary policy is reinforced, rather than dissipated, by
the export sector under a system of flexible exchange rates.
Fourth, over the longer run, the mix and interaction of fiscal and monetary
policies can be of great importance. A fiscal policy that keeps the budget surpluses
intact makes possible an easier monetary policy in the sense of making a lower interest
rate compatible with stable inflation. Although crafted for its short-run effects, an
easier monetary policy has the long-run effect of fostering capital formation and a
more rapid rate of growth of sustainable output. On the other hand, a long-run fiscal
policy of using some or all of the surplus for tax reduction is a policy that is expected
to yield higher consumption and higher interest rates as the Federal Reserve must
offset the expansion of demand with a tighter monetary policy. Higher interest rates
tend to encourage less capital formation and/or a larger trade deficit.
For these reasons, many economists share the view of Treasury Secretary Paul
O’Neill, who said in his confirmation hearing that the Fed is the “first line of action”12
to prevent recessions and that of Professor John Taylor, a well-known
macroeconomist and now an undersecretary of the Treasury, who said,
U.S. monetary policy has been doing a good job in recent decades at keeping
aggregate demand close to potential GDP.... It seems hard to improve on this
performance with a more active discretionary fiscal policy, and an active
discretionary fiscal policy might even make the job of monetary authorities more
difficult. Empirical evidence suggests that monetary policy has become more
responsive to the real economy, suggesting that fiscal policy could afford to
become less responsive.13
Another way to think about the role of fiscal policy is to consider that monetary
policy has been delegated the task of maintaining high employment and stable inflation
by Congress. To argue that expansionary policy is needed implies that either
monetary policy has responded insufficiently or has been ineffective. It is difficult to
make a compelling argument that monetary policy has responded insufficiently in the
first nine months of 2001 when interest rates have been lowered on nine separate
occasions by a cumulative total of 4.0 percentage points. Whether it has been
ineffective since investment spending was negative in the first two quarters is more
debatable. It should be noted, however, that any tax cut aimed at investment, saving,
or business works through the same channel as monetary policy – by raising the
12 Joseph Kahn, op. cit.
13 John Taylor, op. cit., p. 35.

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(after-tax) rate of return on investment. In the case of monetary policy, this occurs
because monetary policy lowers the cost of borrowing.
The Longer Run Effects of Tax Reduction
In general, many economists would support the concept that lower taxes made
possible through lower government spending would increase the long run sustainable
rate of economic growth. There is an important distinction between this concept and
a tax reduction that is almost entirely offset by lower budget surpluses rather than by
lower government spending, as all recent proposals plan to do. This distinction has
important consequences for national saving and private investment.
Important to the long run ability of an economy to grow is its ability to add to
its capital stock. Capital is necessary to ensure that additions to the labor force have
the machinery, tools, and infrastructure with which to produce additional output. In
addition, there is considerable evidence that the growth in productivity, which is the
means by which per capita income and living standards grow, also depends on capital
formation as capital often embodies new technologies, the basis for productivity
growth.14
The ability of a nation to enhance its capital stock is directly related to how large
a fraction of its income it saves. Saving in the United States comes from several
sources. A majority comes from businesses. Households also play a critical role since
they are an important source of net saving on which an enlarged capital stock
depends.15 However, government itself plays a role in determining the national saving
rate. Investment is only possible with saving, and national saving can only come from
private saving, business saving, or government saving. When the government runs
surpluses, it is thought to increase national saving; when the government runs deficits,
it is thought to decrease national saving, all else being equal.16 The major change in
14 In the neo-classical growth model developed by Professor Robert Solow, an increase in the
saving rate would initially increase the growth rate, but the growth rate would eventually
return to its steady state. By contrast, endogenous growth theory has stressed the beneficial
interaction between technological improvement and other aspects of the economy, like capital
formation.
15 A great deal of the saving done by businesses is used to replace the capital that is exhausted
producing output. Thus, what is important for the growth in the capital stock is net saving
or that over and above what is used to replace the capital consumed in the production of
output. For an overview of U.S. saving, see CRS Report 98-580E, Saving in the United
States: Why Is It Important and How Has It Changed?, by Brian Cashell and Gail Makinen,.
16 Contrary to the conventional view, some influential economists argue that the national
saving rate is unaffected by federal budget deficits or surpluses. Households, they argue, will
alter their saving rates to offset any change in the federal rate. Household behavior, they
argue, is motivated by concerns about the private capital stock inherited by future generations.
Economists who subscribe to this view would argue that all of the tax cuts that reduce the
federal budget surplus will be saved by the household sector. Since they will not be spent,
these economists would argue that tax cuts will not stimulate aggregate demand. They will
merely change the sector of the economy where the national saving is done. This theory is
(continued...)

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the federal fiscal regime that occurred during the mid-1990s, in which a protracted
string of budget deficits gave way to budget surpluses, has been widely hailed by
economists as a regime that is conducive to capital formation because it raised the
national saving rate by freeing resources that had been invested in federal debt for
profitable private investment.
From the perspective of the longer run, a tax reduction plan that reduces the size
of the government budget surplus is not conducive to the long-run formation of
capital. If it leads to lower national saving, it favors the use of resources for
consumption rather than capital formation. To the extent that lower national saving
is replaced by foreign saving, more U.S. capital will be supplied by foreigners and the
rewards to that capital will accrue to them.
There is, however, another possible longer-run consequence from a tax
reduction: how it affects the incentive structure for working, saving, investing, and
risk taking. Individuals are motivated to work, for example, not by their gross salary,
but by their after-tax salary. If taxes are reduced in a way that raises their after-tax
income, this may provide an incentive to work more or, in the words of the
economist, to substitute work for leisure. The same is true for saving. If the after-tax
reward is increased, individuals may be encouraged to substitute saving for
consumption. These effects are known as substitution effects.
While this analysis has much to recommend it, it neglects another part of the
incentive structure: the effect of an increase in income on individual behavior. For
example, if after-tax income rises, individuals may feel sufficiently richer to want to
engage in more leisure activity. Hence, they desire to work less. Similarly, if the
after-tax reward for saving rises, individuals with targeted saving objectives will be
able to save less of their income and still achieve their goals. These effects are known
as income effects.
The net outcome will depend on the strength of the substitution effect relative
to the income effect. There is no straightforward method to measure labor and saving
responses. Estimates are dependent on economic modeling which, in turn, is
dependent on the assumptions made in the model. Different models yield vastly
different results ranging from large responses to insignificant responses.17 Thus, it
remains unclear whether these incentive effects necessarily produce significantly more
work, more saving, more investment, or more risk taking.18 And even if tax cuts
16 (...continued)
popularly referred to as “Ricardian Equivalence.”
17 It should also be noted that different types of individuals have been estimated to have
different responses to tax changes. For example, there is evidence that the labor supply of
married women and individuals on the threshold of retirement is much more responsive to tax
changes than the labor supply of married men. Thus, the recipient of any particular tax cut
will be important in determining how much growth the tax cut generates.
18 It is difficult to find evidence that tax cuts have positive effects on labor supply and
household saving in the United States. Over the past decade, for example, the labor force
participation rate in America has hardly changed. In 1990 it averaged 66.5 % while during
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CRS-11
increase the incentive to save, unless the entire tax cut is saved, the national saving
rate will have to decrease since the reduction in the budget surpluses will be larger
than any increase in personal saving.19
Reductions in income taxes are unique because they directly raise the return to
both saving and labor. Most other types of taxes directly affect only one or the other.
For example, a reduction in the payroll tax raises the return to labor, while a reduction
in the capital gains tax raises the return to saving through certain types of assets (e.g.,
equities). Reductions in the corporate tax rate are assumed to result in large part in
a shift from government saving to higher business saving, since businesses are
expected to use the tax saving in only three ways in the long run: to finance new
investments, to pay off debt, or to return to shareholders. The first two are forms of
saving, and whether the third leads to saving or consumption depends on what
shareholders decide to do with it. Still, if new private saving does not entirely offset
the loss in public saving that is financing the reduction in capital gains taxes or
corporate taxes, then long run growth will be lower.
Using the surpluses for tax reductions may offset at least some the negative
effects that reduced surpluses have on long-term growth. Alternatively, using the
surpluses for higher government spending or tax cuts targeted at promoting non-
economic behavioral changes are unlikely to have offsetting effects on growth.20
Evaluating the Long Term Context
The discipline of economics revolves around the study of what makes people
happy, which economists call utility, and happiness (at the least the kind that
economists can measure) comes through consumption. If the economy is at full
employment, economists regard a decision between using a budget surplus for debt
reduction rather than tax cuts and/or increased government spending as a decision
between shifting consumption to the present or future. Most tax cuts to individuals
18 (...continued)
2000 it averaged a little over 67 %. The household saving rate has declined from 6.5% of
GDP during 1992 to 0.7% of GDP during 2000 despite the incentives to save provided by
IRAs, Roth IRAs, and various 401(k) plans. For a more detailed explanation of supply side
effects, see CRS Report 94-1000S, Dynamic Revenue Estimating, by Jane Gravelle. The
academic debate on the magnitude of supply side effects can be found in the symposia Supply
Side Economics: What Remains?, American Economic Review, v. 76, n. 2, May 1986 and
Tax Policy: A Further Look at Supply Side Effects, American Economic Review, v. 74, n. 2,
May 1984.
19 If the entire tax cut is saved, it can have no short run anti-recessionary effect. That effect
depends on some part of the increase in disposable income being spent. Relevant to this issue
is the income distribution of tax reduction beneficiaries. Individuals at higher income levels
would be expected to save a higher proportion of an addition to their disposable income than
lower income individuals.
20 Higher government spending or targeted behavioral tax cuts would only have offsetting
effects on growth if they promoted work, saving, or investment. Government investment is
an example of spending that would have an offsetting effect, although how much different
types of government investment increase economic growth is controversial.

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CRS-12
will increase present consumption, unless taxpayers save it entirely, because it is
financed by a reduction in the projected budget surplus. Since there is no “free lunch”
in economics, today’s increased consumption results in lower future consumption
because, as explained above, a lower national savings rate causes lower investment
and a smaller future economy.21 Saving the surpluses, alternatively, results in higher
future consumption, which must be financed by lower consumption today (because
income is saved instead of consumed today.)22
Economic theory does not suggest whether the government should pursue a
policy of higher present consumption (by cutting taxes) or higher future consumption
(by using the surplus to pay down the national debt.) Such actions represent a
transfer of income (from future to present generations, in the case of lower taxes, and
from present to future generations, in the case of debt reduction) that increases the
utility of one generation at the expense of the other’s utility. The desirability of any
income transfer must be based on a value judgement of equity and fairness.
When the government is running a deficit, economic theory has a clearer
suggestion about its long-run effects. In that case, theory suggests that the
government is lowering saving, and hence growth, below what individuals would
choose on their own. In today’s case, when the government is running a surplus, the
argument is less clear. The burden of proof is on those arguing to maintain a surplus
to demonstrate that the government is not making people worse off by forcing them
to save more than they desire (and hence making them switch from greater present
consumption to greater future consumption in a way that lowers their overall utility.)23
The best argument that can be made for forcing a higher rate of saving through
budget surpluses relates to the enormous demographic shift that the United States will
experience in this century. As the “baby boom” generation retires, the ratio of
workers to retirees is projected to plummet from 3.4 today to 2 around 2050. At
present, Social Security and Medicare are funded on a “pay as you go” basis, where
benefits to today’s retirees are funded by today’s workers. Under the current
structure, both Social Security and Medicare benefits will exceed payroll tax funding
21 In the perfect capital mobility model, the economy would be equally large, but future
American consumption would still be lower because the benefits of the growth would accrue
to the foreign owners of capital.
22 See CRS Report RL30520, The National Debt: Who Bears Its Burden?, by Gail Makinen.
23 Economists are generally inclined to believe that people can choose the distribution of their
own lifetime consumption best if perfect (saving) markets exist and if individuals are perfectly
rational and well-informed. From this perspective, accumulating surpluses are forced saving
that is reducing people’s utility now more than it is increasing it in the future. Taking this
argument to its logical conclusion would lead one back to Ricardian Equivalence: people are
already saving at an optimal level, and anytime the budget surplus increases (or decreases),
private saving will decrease (or increase) to perfectly offset that change. Reality is more
complex, for example because some people are not concerned about the distant future (such
as those people who do not have children) and because much saving for retirement is replaced
by Social Security.

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in 2016.24 There is a consensus that funding these programs will place a large burden
on future generations,25 unless economic growth can be accelerated. There are many
policy options that may increase growth, but the surest path to accelerated economic
growth is to increase the national saving rate. Using the budget surpluses for debt
reduction or entitlement reform26 is not the only way, but it is the most direct way, to
increase the national saving rate.27 For this reason, about 75% of recently polled
economists opined that debt reduction or reforming Social Security and Medicare
were better uses of the projected surpluses than increased government spending or
lower taxes.28
While there are budget surpluses projected throughout the 10-year budget
window under current policy, the fiscal imbalance caused by the retirement of the
baby boomers suggests that this trend would quickly be reversed. The national debt
is projected to be reduced quickly in the next few years if the entire unified budget is
saved. After the debt is eliminated around 2010, the government would accumulate
private assets until around 2020. But after 2020, the rapid retirement of the baby
boomers will cause large budget deficits to reappear. These unfunded liabilities are
forecast to exhaust the government’s stock of private assets in about 10 years. After
that, the unfunded liabilities would cause the federal debt to rise to unsustainable
levels above 200% of GDP in mid-century. Before this point, government spending
would need to be sharply reduced or taxes would need to be sharply increased.29
Further tax cuts would only worsen this outlook.
Another way to view the long-term perspective is in terms of inter-temporal tax
smoothing. Demographics suggest that government spending will sharply increase in
the future unless benefits paid to the retired or all other government spending are
sharply cut from current levels. Thus, the government has two choices – to sharply
increase taxes in the future as government spending increases or to raise taxes by a
24 Estimates from Trustees of the Federal Old-Age and Survivors Insurance and Disability
Insurance (OASDI) Trust Funds, A Summary of the 2001 Annual Reports, March 2001.
25 Many economists argue a more economically meaningful federal budget would include these
future liabilities when calculating today’s budget balance. If this were done, then today’s
budget would be in deficit rather than surplus. The “fiscal gap” measure calculated in the
Congressional Budget Office, Long Term Budget Outlook, October 2000 is one method of
making this measurement.
26 Entitlement reform would increase national savings if and only if it increased the present
discounted value of all future funding relative to the present discounted value of future
benefits (and the savings were not redirected to other spending or tax cuts.) Other forms of
entitlement reform may be less dependent on the maintenance of budget surpluses.
27 This concept is explained at greater length in CRS report RL30708, Social Security,
Saving, and the Economy by Brian Cashell,.
28 “Poor Grades for Al and George,” The Economist, September 28th, 2000. Respondents
were 54 full-time academic economists who had served as referees for the American Economic
Review during 1999.
29 Estimates are from CBO, Long Term Budget Outlook, October, 2000. For a more detailed
discussion, see CRS report RL30925, Surpluses, Zero Debt, and Unfunded Liabilities: What
Are the Policy Options?, by Marc Labonte,.

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CRS-14
smaller amount at present, producing surpluses in the short term which increase
growth and decrease the government’s interest outlays. If one believes that taxation
significantly lowers growth and causes efficiency losses, it is preferable to raise taxes
by a smaller amount today because sharp tax increases in the future would cause a
larger cumulative efficiency loss even though there are fewer years of high taxation.
Would a Permanent or Temporary Tax Cut Be a
More Effective Stimulus?
To jumpstart the economy, lawmakers are considering both temporary and
permanent tax cuts.30 In the standard model, a permanent tax cut is thought to be
more stimulative (i.e., more of it will be spent) than a temporary tax cut. These
results stem from the insights of the life cycle savings model. The life cycle model
suggests that individuals desire to smooth their consumption over their lifetime rather
than base their present consumption on their present income. Thus, people save for
retirement so they are not forced to lower their standard of living when they stop
working. In the life-cycle model, a temporary increase in income, in this case from
a tax cut, would be spent little by little over one’s lifetime. By contrast, a permanent
tax cut would be spent at the same rate as the rest of one’s current income is spent,
because the tax cut would be received every year in the future.
These results are a little too naive to be accepted at face value, however. Since
tax rates change all the time, rational individuals would not necessarily base their
consumption on the tax cut they receive under current law. They should instead base
their consumption on what they believe, based on their best knowledge, their tax rate
will be in the future given likely changes in the future tax code. If they believe that
a tax cut passed today could not be sustained, then their consumption behavior would
vary little from their behavior in light of a temporary tax cut. For example, a law
could be passed today that permanently eliminated all taxes but kept government
spending constant. Surely, a rational individual would not base their consumption
decisions on a belief that taxation would remain at zero. Another reason that
temporary tax cuts are less stimulative in the life-cycle model is the assumption that
households can always borrow against future anticipated income. If this assumption
were relaxed, then a temporary tax cut could enable households to make new
purchases they would otherwise be unable to make, thus stimulating aggregate
demand.
Investors also may react differently to a temporary tax cut than a permanent tax
cut, however. This relates to the theory presented earlier that long term interest rates
are currently high because of investor beliefs about future government borrowing. If
this theory is correct, then a permanent tax cut would lead investors to believe that
the government will undertake even more borrowing in the future. This would make
long-term interest rates even higher today, crowding out more private investment
today, and making the tax cuts less stimulative. By contrast, a temporary tax cut
30 One notable exception is an investment tax credit, which would be more stimulative in the
short run if it is temporary because businesses would only have a short window of opportunity
to take advantage of the tax break.

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would have little effect on future borrowing by the government. In this theory, it
would therefore have little effect on future interest rates and cause little crowding out
of private investment. It may be for this reason that Federal Reserve Chairman Alan
Greenspan and former Treasury Secretary Robert Rubin reportedly recommended that
tax cuts be temporary, as they “warned that using too much of the federal budget
surplus could unnerve the markets, raising long-term interest rates...”31 Thus,
temporary tax cuts provide a better stimulus if they lead to significantly less crowding
out, while permanent tax cuts provide a better stimulus if they generate a significantly
smaller savings response because people act in the way the life-cycle model suggests.
The long run advantage of a temporary tax cut is that it would not represent a
continual reduction in public saving, and probably national saving, into the future.
Thus, relatively less private capital investment would be crowded out in the future.
Conclusion
Congress is currently considering several tax cuts whose stated primary aim
would be to stimulate the slowing economy. Any proposal would affect equity,
fairness, allocative efficiency, and the macroeconomy. This paper evaluates only the
macroeconomic effects of a tax reduction. From a macroeconomic perspective, a plan
to reduce budget surpluses through lower taxes can be judged by its short-run effects
and long-run effects. The short-run effects concern how the tax cut would affect the
business cycle. The long-run effects concern how the tax cut would affect long-run
growth.
For a tax cut to have valuable short-run effects, the economy must be near or in
recession. Otherwise, the effect of the tax cut on growth would be dissipated through
a larger current account deficit, higher interest rates (and reduced investment), and
higher inflation. It must be large enough to have a measurable effect on people’s
behavior and expectations. It must be spent rather than saved. (Tax cuts that
promote saving are contractionary in the short run; if they were expansionary, then
the government could accomplish a greater stimulus by instead maintaining public
saving through the preservation of the surplus.) If the proposal meets all of these
criteria, its effectiveness should be compared to the effectiveness of monetary policy,
the other short-run stabilization tool.
Over the longer run, a tax cut can increase economic growth if it has a positive
effect on the incentives to work, save, and invest. These incentive effects are unlikely
to counteract a recession in the short run since a recession is a situation where
existing resources are being underutilized. To have a positive effect in each of these
areas, the substitution effect (e.g., working more because work is more highly
rewarded) must dominate the income effect (e.g., working less because less work is
required to achieve the same standard of living.) But the tax cut will only have a
positive effect on long-run growth if it generates more saving/investment and labor
supply than the reduction in national saving attributable to the lower budget surplus.
31 Sue Kirchoff, “Greenspan Offers Ideas on Economic Stimulus Plan,”Boston Globe,
September 26, 2001, p. C1.

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The intended purpose of a tax cut is crucial in evaluating the effectiveness of the
measure. Most importantly, tax cuts that are most effective at boosting aggregate
demand in the short run are typically least effective at increasing the sustainable rate
of growth in the long run, and vice versa. For a tax cut to boost aggregate demand
in the short run, it must boost either consumer or investment spending. Reductions
in individual taxes would be expected to boost consumption, and tax reductions for
low-income individuals are thought more likely to be spent since those individuals
have a lower average saving rate. By definition, if tax reductions to low-income
individuals generate more spending, then they will generate less saving. With less
saving, less capital investment can be financed and long-run growth will be lower.
By contrast, a reduction in the capital gains tax raises the after-tax rate of return
on individual investment in assets. Assuming the substitution effect dominates, this
tax cut gives an incentive to spend less, which would lower aggregate demand in the
short run, and save more, which would contribute to long run growth.32 To increase
overall saving and growth in the long run, however, the increase in private saving
must exceed the loss in public saving caused by the reduction in the surplus.
Some lawmakers find proposals to lower different business taxes appealing
because these proposals may have a positive effect on both aggregate demand in the
short run and sustainable growth in the long run. Both an investment credit and a
reduction in the corporate tax rate would raise the after-tax rate of return on capital.
This would give businesses an incentive to invest more, which would both boost
aggregate demand in the short run and contribute to long run growth. An investment
credit is thought to generate more investment in the short run because it only benefits
new investment, whereas a reduction in corporate tax rates benefits both new and old
investment (i.e., shareholders). The portion of the tax cut returned to shareholders
only boosts aggregate demand in the short run if the shareholders increase their
consumption. Critics question whether firms respond quickly enough to changes in
tax rates, particularly during a recession, for these proposals to amount to a
meaningful fiscal stimulus in the short run.33
For those who argue in favor of a reduction in capital gains taxes or business
taxes, it should be noted that their effects flow through the same channel as
expansionary monetary policy in the short run or increasing the surplus in the long run
– by raising the (after-tax) rate of return on investments. Expansionary monetary
policy raises the rate of return on investment by lowering the inflation-adjusted cost
of borrowing in the short run and increasing the surplus raises the rate of return on
investment by raising the national saving rate, and thereby lowering the cost of
borrowing. Thus, reductions in any of these three tax rates would only be preferable
to monetary policy in the short run and maintaining the surplus in the long run if it
could generate a greater investment response than those alternatives.
32 For more information, see CRS Report RS21014, Economic and Revenue Effects of
Permanent and Temporary Capital Gains Tax Cuts, by Jane Gravelle,
33 For more information, see CRS Report RL31134, Using Business Tax Cuts to
Stimulate the Economy, by Jane Gravelle.

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